The price you charge for your product or service is one of the most important business decisions you make. Setting a price that is too high or too low will - at best - limit your business' growth. At worst, it could cause serious problems for your sales and cashflow.
If you're starting a business, carefully consider your pricing strategy before you start. Established businesses can improve their profitability through regular pricing reviews.
There are two crucial points to consider when setting your prices:

• The price and sales levels you need to set to make sure your business is profitable.
• Where your product or service stands compared with your competition.

This guide shows you:

• how to build a pricing strategy
• how to work out your costs and pricing to make sure your business is profitable
• different methods of pricing for different markets

Knowing the difference between cost and value can increase profitability.

The key differences

• The cost of your product or service is the amount you spend to produce it.
• The price is your financial reward for providing the product or service.
• The value is what your customer believes the product or service is worth to them.

For example, the cost for a plumber to fix a burst pipe at a customer's home may be £5 for travel, materials costing £2.50 and an hour's labour at £10. But the value of the service to the customer - who may have water leaking all over their house - is far greater than the £17.50 cost. So the plumber may charge £50, for instance.
Your pricing should be in line with the value of the benefits that your business provides for its customers, while also bearing in mind the prices your competition charges.
To maximise your profitability, find out:

• what benefits your customer gains from using your business
• the criteria your customers use for buying decisions - for example, speed of delivery, convenience or reliability
• what value your customers place on receiving the benefits you provide

Wherever possible, set prices that reflect the value you provide - not just the cost.

Every business needs to cover its costs in order to make a profit. Working out your costs accurately is an essential part of working out your pricing.

Divide your costs under two headings: fixed and variable.

Fixed costs are those that are always there, regardless of how much or how little you sell, for example rent, salaries and business rates.

Variable costs are those that rise as your sales increase, such as additional raw materials, extra labour and transport.
When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then make a contribution towards covering your fixed costs - and making profits.

For example, a car dealership has variable costs of £9,000 per car sold and total fixed costs of £200,000 a year that must be covered. If the company sells 80 cars each year, it needs a contribution towards the fixed costs of at least £2,500 per car (£200,000 divided by 80) to avoid making a loss.

Using this structure, you can assess the consequences of setting different price levels:

• If the car dealership sells cars at less than £9,000 (the variable cost per car), it will make a loss on each car it sells and not cover any of its fixed costs.
• Selling 80 cars at £9,000 will mean a loss of £200,000 per year as none of the fixed costs will be paid for.
• Selling cars at £11,500 will result in breaking even, assuming the target of 80 cars are sold, ((£11,500-£9,000=£2,500) x 80 = £200,000 = fixed costs).
• Selling cars at £12,000 will result in a profit, assuming 80 cars are sold, ((£12,000-£9,000=£3,000) x 80 = £240,000 (£40,000 above fixed costs)). 
• If more or fewer than 80 cars are sold, profits will be correspondingly higher or lower.

There are two basic methods of pricing your products and services: cost-plus and value-based pricing. The best choice depends on your type of business, what influences your customers to buy and the nature of your competition.

Cost-plus pricing
This takes the cost of producing your product or service and adds an amount that you need to make a profit. This is usually expressed as a percentage of the cost.
It is generally more suited to businesses that deal with large volumes or which operate in markets dominated by competition on price.
But cost-plus pricing ignores your image and market positioning. And hidden costs are easily forgotten, so your true profit per sale is often lower than you realise.

Value-based pricing
This focuses on the price you believe customers are willing to pay, based on the benefits your business offers them.
Value-based pricing depends on the strength of the benefits you can prove you offer to customers.
If you have clearly defined benefits that give you an advantage over your competitors, you can charge according to the value you offer customers. While this approach can prove very profitable, it can also alienate potential customers who are driven only by price and can also draw in new competitors.

In many markets, a high price contributes to the perception of the product as being of premium value. The perception of your product or service is important.

Will this be the image that will get customers to buy from you? Are your customers more price-conscious? If so, you can build in some pricing tactics.

Find out what competitors are doing. Phone your rivals and ask them for a quote. You can use this information as a framework.

It's probably unwise to set your prices too much higher or lower without a good reason. If you price too low, you will just be throwing away profit. If you price too high, you will lose customers, unless you can offer them something they can't get elsewhere.

It can be useful to charge different prices to different customers, eg to customers who purchase repeatedly, or buy add-on or related products, as a thank you for their loyalty.

Customers who are expensive to satisfy will be less profitable, unless you charge them higher prices. One-off sales may cost you more than repeat business.
Decide which pricing method is best for you - cost-plus or value-based.

Make sure your prices cover your costs and can deliver a profit. Leave yourself some room for change if necessary. You can always change your prices, but it's wise to think carefully before you do.

Discounting
Offering specially reduced prices can be a powerful tool. This could be a clearance discount to sell old stock, or you could offer bulk discounts to encourage larger orders. You should be able to make these more profitable through lower costs.
But be careful. If you discount too much, customers may question your full-rate pricing or see you as a cheap option, making it difficult to charge full-rate prices in the future.

Odd value pricing
Using the retailer's tactic of selling products for £9.99 instead of £10 can be useful if price is an essential part of customers' buying decisions. It can help to show you've discounted every penny you can.

Selling one item at £2.98 instead of £3 may not seem much, but once the customer buys multiple items at the discounted price, they would save a decent amount.

Loss leader
This involves selling a product at a very low price purely to win new customers. You may include some products priced at cost in your range for this purpose, or you can offer lower prices to new customers, reverting later to normal prices.

Skimming
If you have a unique product or service, you can sell it at a high price. This is known as skimming - but you need to be sure that what you are selling is unique. Otherwise you may just price yourself out of the market if there is credible competition.

Penetration
This is the opposite of skimming - starting at a low price and gaining market share before competitors catch up with you. Once you have a loyal customer base, you should be able to find ways to raise prices later.

There will be times when you need to change your prices. But before you do, you should analyse the impact on your profitability of any proposed price change.
There are two key questions you will need to answer:

• What effect will the price change have on the volume of sales?
• What will the effect be on the profit per sale?

Remember that if you are increasing prices, your profitability can still rise even though your turnover may drop.
If you are increasing your prices, always explain to your customers why you are doing it. You can use the price change as an opportunity to re-emphasise the benefits you offer. A good explanation can also strengthen your relationship with a customer.
There are ways that you can hide price increases. For example, you might:

• introduce new, higher-priced products or services and make old, cheaper ones obsolete
• lower the specification - and your costs - while maintaining the same price

But be aware that hiding price increases can risk adverse reactions from customers if they realise what you are doing.
You should never take the decision to lower prices lightly. Low prices often go hand-in-hand with poor-quality service - is this the image you want to create for your business?
Concentrate on building profits rather than cutting prices to build up sales. In most circumstances, your customers decide to buy from you because of the benefits you offer, along with your price. It is rare for the decision to be made on price alone.